A Closer Look at Plains All American Pipeline’s Distributable Cash Flow as of 1Q 2012

Revenues in 1Q 2012 increased 3.8% vs. the prior quarter and 19.8% vs. 1Q 2011 (by comparison, revenues in 1Q 2011 increased 6.4% vs. 4Q 2010 and were up 25.6% over 1Q 2010). Earnings before interest expense, depreciation & amortization and income taxes (EBITDA) in 1Q 2012 decreased 1% vs. the prior quarter and were up 17.2% over the prior year period. However, adjusted EBITDA in 1Q12 was 18% above the $400 million mid-point of the guidance provided by management for that quarter. The Partnership’s first-quarter operating results was not impacted by the acquisition of the Canadian natural gas liquids business from a subsidiary of BP Corporation North America, Inc., which closed effective April 1, 2012.

Given quarterly fluctuations in revenues, working capital needs and other items, it makes sense to review trailing 12 months (“TTM”) numbers rather than quarterly numbers for the purpose of analyzing changes in reported and sustainable distributable cash flows.

In an article titled Distributable Cash Flow (“DCF”) I present the definition of DCF used by Plains All American Pipeline L.P. (PAA) and provide a comparison to definitions used by other master limited partnerships. Using PAA’s definition, DCF for the TTM ending 3/31/12 was $1,253 million ($8.19 per unit), up from $799 million in 2010 ($5.74 per unit) in the TTM ending 3/31/11. As always, I first attempt to assess how these figures compare with what I call sustainable DCF for these periods and whether distributions were funded by additional debt or issuing additional units.

The generic reasons why DCF as reported by the MLP may differ from sustainable DCF are reviewed in an article titled Estimating Sustainable DCF-Why and How. Applying the method described there to PAA results through March 31, 2012 generates the comparison outlined in the table below:

Table 1 indicates net cash provided by operating activities in the TTM ending 3/31/12 increased by $1,506 million vs. the TTM ending 3/31/11. The two major components of the large increase are: (i) net income increased by $498 million; and (ii) working capital consumed $378 million in the TTM ending 3/31/11 but generated $638 million in the TTM ending 3/31/12, for a net difference of $1,016 million. These two items total $1,514. The balance is accounted for by other items. For the TTM ending 3/31/12 there do not seem to be material differences between reported DCF and sustainable DCF.

As explained in prior articles, in calculating sustainable cash flow I generally do not include working capital generated but I do deduct working capital invested. Despite appearing to be inconsistent, this makes sense because in order to meet my definition of sustainability the MLP should, on the one hand, generate enough capital to cover normal working capital needs. On the other hand, cash generated from working capital is not a sustainable source and I therefore ignore it. When there are large swings in working capital, as is the case here, my approach results in large swings in sustainable DCF and in coverage ratios based on sustainable cash flow, as seen in Table 1 and Table 2.

In the TTM ending 3/31/11, $378 million of cash was used to increase working capital. The DCF number reported by PAA ignores this amount. The sustainable DCF number does not, hence the low coverage ratio in that period.

In the TTM ending 3/31/12, $638 million of cash was generated by working capital. The two main components of this were the liquidation of crude oil inventory that had been stored in the contango market (for an explanation of backwardated and contango markets click here) and an increase in accounts payable. I do not view these as sustainable sources of cash. The number reported by PAA ignores this amount because, under PAA’s definition, reported DCF always excludes working capital changes, whether positive or negative.

PAA has increased its distributions per unit for the last 11 consecutive quarters, so the coverage ratios above, which are calculated based on distributions actually made during the relevant period, may be slightly overstated. Distributions actually made totaled approximately $3.9725 per unit for the 12 months ended 3/31/12, while the current distribution level is at $4.18 per annum. This ~5% increase does not materially reduce the very robust coverage ratio.

Other factors, however, could reduce coverage ratios in 2012. The previously noted $498 million increase in net income in the TTM 3/31/12 over the comparable, prior year, period is so large that further analysis is required to assess the likelihood of 2012 results surpassing 2011. A useful starting point to assess this is the following table:

The extraordinary growth in Supply & Logistics segment profit is attributed by management in one part to two main factors. One is the “…impact of higher volumes due to increased production related to the active development of crude oil and liquids-rich resource plays. The increase in volumes was primarily a result of increased drilling activities in the Bakken, Eagle Ford Shale, West Texas, Western Oklahoma and Texas Panhandle producing regions…” The other relates to “…increased margins related to production volumes exceeding existing pipeline takeaway capacity in certain regions and the associated logistics challenges”. Management cautions that the margins delivered in 2011 may not be repeated: “…a normalization of margins may occur as the logistics challenges are addressed” (quotes are from PAA’s 2011 10-K). Results for 1Q 2012 indicate a decline in that segment’s contribution:

I find it helpful to look at a simplified cash flow statement by netting certain items (e.g., acquisitions against dispositions) and by separating cash generation from cash consumption. Here is what I see for PAA:

Net cash from operations, less maintenance capital expenditures, less cash related to net income attributable to non-controlling partners exceeded distributions by $1,066 million in the TTM ending 3/31/12 2011 and by $428 million if we exclude the $638 million in working capital liquidation noted above. Clearly PAA is not using cash raised from issuance of debt and equity to fund distributions. The $428 million excess enables PAA to reduce reliance on the issuance of units or additional debt to fund expansion projects. In fact, of the $2.9 billion gross amount spent in the TTM ending 3/31/12 on growth capital projects and acquisitions (net of sale proceeds), only $1.9 billion was funded by debt and the issuance of additional partnership units; the balance was funded from internal cash flow. This is an impressive achievement.

Capital growth projects and acquisitions for 2012 have already been prefunded to the tune of ~$400 to $460 million via additional partnership units sold in March 2012. My hope is that PAA funds the balance with debt (which it can easily do without exceeding its announced credit profile parameters) and/or internally generated cash flow in order to minimize dilution to limited partners.

There is no reason to doubt PAA’s ability to achieve an 8%-9% distribution growth in 2012, and even beyond, despite the fact that the general partner gets 50% of any distributions in excess of $2.70 per unit per annum. However, if a normalization of margins in the Supply & Logistics segment does occur, the quarterly results in the last three calendar quarters of 2012 may disappoint investors when compared to the prior year period. For a further drill-down that reviews the breakdown by quarter of the numbers in this report, click here. This may put pressure on PAA’s unit price. Additional dilution would add to this concern, hence my hope that management will avoid it.

PAA’s currently yields 5.39% (as of 5/18/12) and, at $77.50 per unit, is 8.3% off its 12-month high. For investors not fearful of the market downturn we are currently in the midst of, the current price level should be attractive given PAA’s size, strong management team, portfolio of growth projects, excess cash from operations, history of minimizing LP dilution and performance track record.

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